Canada Revenue Agency clarifies SR&ED eligibility as industry pushes for new tax treatment to encourage commercialization

A new set of policy documents for corporate R&D tax credits helps to clarify the key details of the government's administration of the scientific research and experimental development (SR&ED) tax incentive program, says one of Canada's foremost experts on the program. The documents reinforce the increasing emphasis on the scientific method that the Canada Revenue Agency (CRA) has been placing on auditing company claims for their R&D work and indicate that it will insist on firms providing contemporaneous records of work conducted for SR&ED eligible projects.

The documents reaffirm the current approach the CRA takes towards SR&ED claims which is narrower that in the program's early years and helps to explain, in part, the declining cost of the program. It peaked at more than $4 billion annually but is now projected at between $3.3 bill and $3.5 billion a year, with most of that reduction occurring in the areas of manufacturing and software development.

"Under the clarified guidelines, there must be fundamental technological uncertainty and that leads to real difficulties in shop floor and software environments. It becomes a very heavy limiter," says Dr Russ Roberts, senior VP tax, finance and advocacy for the CATA Alliance. "Development models are very interactive with the work you're doing in these areas and if you try and isolate focus and micromanage, it's very difficult. The program doesn't work in those settings."

The CRA launched its SR&ED Policy Review Project in late 2010 and released the new policy documents in late December. They include a new format that makes is easier to provide future updates and new examples to improve understanding the three key criteria for eligibility — scientific or technological advancement, scientific and technical content and scientific or technological uncertainty.

Another new feature is the use of five questions (see box) to be used in conjunction with the three criteria for use by companies when determining whether the R&D they are considering will result in tax credits.

Roberts says that while the clarification of CRA's policies and procedures is welcome, the narrow focus of SR&ED combined with strict auditing practices is making firms think twice about using the program. It's estimated that 70% of claims are now prepared by consultants. He also argues that the program does little to encourage firms to innovate within Canada, which often opt to commercialize their intellectual property (IP) in lower cost and low-tax jurisdictions.

The CRA audit approach combined with the reductions in certain SR&ED eligibility rates (effective April 1/14) are certain to reduce the program's cost even further. The reduction in the tax credit for larger firms and the elimination of capital costs as eligible expenses announced in the 2012 Budget will reduce program outlays by anywhere between $400 and $750 million (R$, March 29 & November 9/12).

Canada should introduce innovation box

The limited scope of SR&ED is prompting CATA to advocate for a framework (as opposed to project-based) approach to firm-level innovation, following the lead of several other countries. The industry association's latest proposal is the adoption of a patent box or innovation box program that would provide preferential tax treatment for firms that successfully exploit their IP inside Canada. The CATA Innovation Box Campaign is part of a larger advocacy initiative called the Competitive Innovation Nation program, which is being directed by high-tech entrepreneur Terence Matthews, chairman of Mitel Networks and Wesley Clover.

UK example of encouraging innovation

The UK is the latest country to introduce a patent box regime, developed by HM Revenue and Customs, a non-ministerial department supported by two agencies and public bodies.

The UK patent box regime allows for a 10% tax on patented profits, far below standard corporate tax rates, to encourage firms that own UK-developed patents outright or have exclusive license rights. The UK regime — which applies to profits derived after April 1/13 — is considered more generous than similar schemes in other countries as a single patent in a larger product such as a car will qualify that product for entering the patent box where a formula is used to determine what percentage of profits are eligible from the technological IP. Sectors expected to benefit from the patent box regime are pharmaceuticals, manufacturing, defence, telecommunications, business services and certain aspects of retail.

In addition to benefitting companies already active in the UK, the government anticipates that the patent box regime will serve as a powerful magnet for multi-nationals seeking the best jurisdiction for high-value investments, particularly when combined with proposed enhancements to the country's R&D tax credits.

The Netherlands innovation box allows for an even broader class of IP with no limit on income inclusion, resulting in a rock-bottom tax rate of 5% . Other countries that have adopted a similar tax incentive for commercialization include Belgium, Hungary, China, Spain and Luxembourg. The US is also actively considering a patent box program.

"SR&ED is more and more focused on the research side of the story. What creates economic benefit is not more research per se but getting this research into products and processes. That's why we're advocating for new programs and the CATA Innovation Box is a response to that," says Roberts. "Other countries like the UK have created these new tax structures to support companies rather than R&D, to capture the research stream for the economy. The government is encouraging us to talk to our community to see where this might go, although we won't see anything about this in the next Budget."

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